Autumn 22 economic outlook: The tipping point

Forget the world you knew

The previous years had been good for the corporate world’s leaders. Lending rates had been kept at historic lows post the 2008 Global Financial Crisis to convince corporations and individuals that they can take investment risks. Meanwhile, unfettered monetary accommodation by central banks ensured that stock prices, a key performance indicator for many boards, would continue to climb. Technological advances prompted the rise of challengers and ample liquidity allowed incumbents to maintain competitive advantage. Small business would challenge and, if successful, would be bought up by their bigger rivals at a premium. Any mistakes, and there was no shortage of them, could be easily covered with cheap credit. Companies were flush with cash, so much so that borrowing to pay dividends was proving beneficial to their capital structures. The cornerstone of this particular ‘House of Cards’ was low inflation. As long as consumer prices did not rise significantly, then cheap money could continue to flow.

The pandemic disrupted businesses, and ensuing inflation threatened the global business model. As Covid subsided, the corporate world was hoping that imbalances would be addressed and the world would return to at least a semblance of pre-pandemic normality. Inflation was there, to be certain, but as supply chains normalised, consensus considered that it had peaked around last December.

The tipping point

The war in Ukraine dashed hopes of a return to 2019. Inflation soared, forcing central banks to turn off the taps of cheap money, sending financial markets into a tailspin. For the first time in over 25 years, corporate debt and equity prices have been concurrently de-rated by their investors.

It is not only the financing model that broke down, but operational business models as well. During the last 40 years, the assumption was that the world was becoming more globalised. War was a regional affair. All companies had to do was to find the cheapest supplier. Market forces and the universal drive towards turning a profit would take care of any risks.

Ukraine has reminded us that this is not the case. The post-Soviet Union order has collapsed, and the world is now unequivocally unbalanced, in search of a new financial, economic and business paradigm. 2022, 2023 and beyond may well prove to be the most challenging years in decades for executive officers and boards. In 1945, Franklin Roosevelt, Joseph Stalin and Winston Churchill decided the shape of the world in the Yalta conference. This time around, the world may be convulsing, but it does not lie in tatters. The need for global leaders to shape it is not absolute. And even if it was, there’s little consensus in that field. Instead, it will be technology and availability of resources that will decide the new economic paradigm. This will come from the bottom up, not the top down. In other words, business leaders should not be expecting solutions from policy makers. They will have to find solutions that fit them and accept that geopolitical risks are elevated. It is from the bottom-up chaos that the new economic paradigm will emerge.

The challenges

Supply chains. Companies are searching for new supply chains, prompted by geopolitical concerns as well as China’s economic and Covid-related convulsions. Over two thirds of executive officers are looking for new supply chain solutions, according to a recent survey. ‘Off-shoring’ has been substituted with ‘friend-shoring’, i.e. finding countries with a stable environment and with traditional trading ties to the origin country of manufacture. Just recently, Apple decided to produce a significant number of iPhone 14s in India instead of China, its traditional hub. In this environment, chasing fewer new vendors, smaller companies find themselves at a disadvantage, as they compete against bigger rivals who can get better pricing due to higher volume. Brexit realities further complicate matters for British businesses.

Inflation and tight labour markets. Inflation is pervasive and affects costs across the board. Tight labour markets, especially in Britain, exacerbate payroll costs and operational risks, as resignations often leave gaps in particular services.

Earnings. Economists surveyed by Bloomberg believe that there’s an over 50% probability that major economies will experience a recession in 2023. Meanwhile, earnings projections by analysts tend to lag economic developments. Official analytics and corporate guidance has not so far produced earnings warnings that would resonate with a recession.

Valuations. It’s not just the earnings, but also the valuations. In the past few years, many CFOs have chosen to shift their capital structures from equity to debt. This is because equity performance was high and bond yields low. The shift would lower the cost of capital, which is the rate that analysts use to discount future cash flows. Now, the situation has reversed dramatically. Bond yields have gone up, raising the cost of debt, while equity returns have tanked. Companies that shifted their capital structure towards debt, find themselves not just with lower projected earnings because of the economic climate, but also lower discounted projected earnings due to the higher rate of discount. This puts a further burden on equity prices and on buyout prices from Private Equity funds. In recent weeks, there has been anecdotal data of PEs selling out their positions or withdrawing from deals at an increasing pace.

The market factor. Markets have not only been responding to idiosyncratic corporate factors, but to systemic ones. The withdrawal of liquidity from the Federal Reserve Bank has caused a significant de-rating in equity prices, making it more difficult for companies to secure financing from markets. Investors have become scared. As a result, surveys suggest that investors prefer CEOs to reduce capital spending. Yet, many find themselves needing to reconfigure their supply chains, lest they risk their whole business model. This is a time when investors and boards may even find themselves in opposing camps.

What now?

We are witnessing the end of the post WWII global order. The changes are significant and unpredictable. Challengers are vulnerable, but incumbents can’t sleep safe either. Many will be swept up by the whirlwinds of shifting markets, economic recessions and the resetting of the world. Some will sell at current valuations, which, in many cases, are still attractive, others will buy competitors, and yet others will find their business models challenged. This is a time of change. We should not expect things to ‘go back to normal’. Boards that think of adaptation, approach change strategically, intellectually, and then focus on pitch perfect execution have a higher probability to survive and thrive.

Published October 2022